The world is rife with awful advice on finances. Everyone from your slimy brother-in-law who cannot seem to hold down a job but always has a hot stock tip to your neighbor’s dippy daughter who barely eked out her communications degree before landing a sales job with the local Edward Jones branch is up for telling you what to do with your money. And what most of them are telling you is wrong.
But this band of motley fools can be forgiven… until they grab a bullhorn and hold themselves out as experts despite their deficiencies.
I recently read an article from a journalist purporting to be a finance expert. He maintained that your down payment on a house should be the maximum you can manage—a preposterous argument that ignores the basics of good finance. Like so many reporters, when they jump out of the objective and into the opinion fray, they come out looking like asses. Worse in this instance is that people could lose their homes from following such bad advice.
This is what former Reuters reporter Felix Salmon wrote:
Linda’s advice, remember, was to maximize the amount that you are forced to pay every month: to “borrow as much as you can reasonably afford.” The problem with that is that the amount you can reasonably afford today is not always the amount you can reasonably afford tomorrow. So when your income unexpectedly falls, or when your expenses unexpectedly rise, suddenly you’re at serious risk of losing your home. The lower your monthly payments, the more likely you are to at least have a safe roof above your head in the event of something like a job loss or a family emergency.
He even goes so far as to portray those who would borrow more and put less cash down as “acting black,” since minorities tend to be more likely to have their homes underwater than Caucasians. In addition to his unfortunate choice of metaphor, Mr. Salmon misunderstands the difference between borrowing more than a property is worth and smartly deploying leverage.
Putting down less, as his colleague Linda proposes, is often the better choice. In fact, a smaller down payment can actually help you avoid default, not increase that risk.
Look at it this way: When we evaluate a company for investment risks, one of the first things we scrutinize is the “current ratio,” or the amount of cash a company has to cover debts it has coming due over the next year. If a company has a low current ratio, like 0.5, then it’s short on cash and likely to either fall behind on its payments or have to raise cash at the expense of its investors. A low current ratio is a bad sign.
However, if a company has a high current ratio—say 2.0—then it has plenty of money to service its debt and cover other expenses on top of that.
If you took Mr. Salmon’s advice, putting as much cash as possible toward your down payment, and looked at your finances like we do a company’s, you’d score poorly.
Imagine you’re part of a young couple, just into your first jobs and buying that first house together. You have a little over $50,000 saved, you did the math, and you can afford to buy a $250,000 house.
In Mr. Salmon’s world, you’d put down $50,000 (20%), borrow $200,000, and wind up with a mortgage payment of about $1,275/month with normal property taxes included, at today’s average mortgage rates.
However, if your bank will go for it, think about putting down only $10,000 instead. You’d have to add in $100 for mortgage insurance at that level, plus a little higher base, bringing those payments up to $1,475/month.
Why then, if it’s $200 more expensive, is Mr. Salmon’s advice dead wrong? Simple: time to recover.
Under Mr. Salmon’s scenario, let’s say two years in you lose your job. Hopefully you’d have put that mortgage savings right into the bank and saved $200 per month for a rainy day fund, i.e., $4,800, or enough to cover your mortgage for less than four months.
Considering that as of last month, the feds pegged the mean duration of unemployment at over nine months, that’s not much of a cushion. You might find yourself taking any job you can land—flipping burgers at McD’s, maybe?—just to make sure you don’t fall behind on those payments and lose the $50K in “equity” you had to a foreclosure.
However, if you’d borrowed more—even if the extra $200 a month came directly out of your piggy bank instead of your paycheck—then you’d have $35,200 remaining to cover your mortgage, or about two years of payments at the higher rate. That’s a much more realistic time to find a comparable job to replace your old one, allowing you to negotiate with confidence.
By borrowing less, you bought yourself much more time to adjust to changing circumstances. If you stretched your down payment instead, you would have failed to self-insure against the risk of income loss and made an unwitting bet that in the next decade you were unlikely to need the extra margin of safety—as it would take that long for your payment savings to catch up to your cushion in the best-case scenario.
In managing your own finances, try to look at the situation as a company would. Don’t starve yourself for working capital, for cash. All that does is increase your default risk, not decrease it. Instead, strike a healthy balance between maintaining a cash cushion and taking on debt.
The unexpected will happen. And when it does, what matters then is not whether your payments are a few points lower. It’s whether your capital reserves will last for two months or two years. The more time you buy yourself to react, the more likely you can land on your feet. And the only way to buy yourself time is to increase your current ratio, to make sure you have enough cash to service your debt.
Mr. Salmon is right in one regard: he puts a high emphasis on peace of mind. But what yields more peace of mind: paying a few bucks less each month and risking your bank account being near empty when bad times come; or knowing you can weather a storm, even if it lasts much longer than average?
I just wish he’d put as big an emphasis on math as he does on psychology…
Unfortunately, there’s a lot of similar-quality advice in the financial world. The only way to protect yourself from taking on bad habit after bad habit is to learn how to separate good, logical financial advice from uninformed opinion.
There is no universal rule to apply here, but you can certainly catch 80 to 90% of the bad with one simple axiom: do the math. Any financial decision is best made by running the numbers on both sides of the coin. What happens in the best case, and what happens in the worst? See what the outcomes are for yourself, and use them to judge.
There are no shortcuts when it comes to money. Advice either adds up, or it doesn’t.
And never trust a blogger, journalist, pundit, or analyst who doesn’t do the same. Any financial advisor who fails to look at risks and rewards in pure dollars and cents is clouding the issue with unnecessary fluff, and probably trying to obscure the facts that contradict his case.
That said, be wary of false mathematical prophets as well. If someone paints an overly rosy picture, always check the inverse, too.
The same principle applies to your investment portfolio. At Casey Research, we’ve long preached rational speculation—the idea that a smart investor can both aim to beat the market and reduce risk by concentrating on a handful of high-potential investments instead of the “spray and pray” approach that most brokers and financial advisors take.
Compare the two models. Imagine you have a portfolio of any size… $10,000 or $10 million.
If you invest Wall Street’s way, you put 80-90% of your net worth into equities, mostly index funds that mirror the overall US or global markets, with a small amount allotted to fixed income.
What’s a reasonable expectation of gains? Well, the US stock market has returned on average about 7% a year over the last century… 9.9% if you only track the S&P 500 and factor in dividends.
How much can you potentially lose? Wall Street’s way, every year you risk nearly all of your assets in highly volatile markets. In 2008, the Russell 1000 Index, which tracks a large number of stocks at the mid-end of the market, lost 37.4% in a year. The S&P 500 was down 37.2%.
Over the past 100 years, on at least half a dozen occasions you would have lost 20% or more in a year. Double that for 10% or more. And we all know how it’s been in recent times, with losing years in 2000, 2001, 2002, and 2008. Unfortunately, losses compound faster than gains—if a market goes down 25% in one year and up 25% the next, then you don’t break even. You’re still down 6.25%.
On the other hand, if you invest like a rational speculator, you carve off 10% of your portfolio and laser in on an investment opportunity or a handful of them that you think can return 100%+ in the next year. The rest of the money, it’s up to you, but we recommend a diversified basket of low-volatility assets—something that won’t rock up and down 37% a year. (Your broker may hem and haw, but that’s only because chances are he’s going to make 90% less money if you only put 10% of your assets into the market.) Fixed income is a great category to consider here, with much lower volatility and stable long-term returns. If interest rates rise again, even CDs, money markets, and the like could easily fill that role.
Now, what would it take to see a 2008-type loss in your portfolio—a loss so bad it takes years of winners to recover from? With a rational speculator’s approach, you’d have to lose 80% of your investment four years in a row. Of course, that would mean not only were you colossally wrong over and over again, but you’d also ignored the basics of speculating: actively managing your investments, controlling your losses, and riding your winners. Had you done that and restricted your maximum loss to an easily manageable number like 40% (we’re being conservative here) or 4% of your overall portfolio, it would take you year after year of consistent misses to end up with a 2008-like hole.
If you come within spitting distance of your target, making an average gain of, say, 60%, added to a stable return with a fixed-income portfolio of something like 4%-5% annually in this environment, you can easily outpace the annual return of the S&P 500. Miss by half, and you still have a solid gain. All the while, your absolute maximum possible loss was just 10% of your portfolio, not 100%.
Looking for stronger return potential? Make it 80% low volatility and 20% speculation (we recommend looking at it like two 10% slices, and spreading them across more than one sector so you don’t become too exposed to one area). In that scenario, a 4% return on the fixed income and a 50/50 success rate on the speculative slices of your portfolio in finding stocks that either double or flop would yield a 14% total return.
You can adjust as you see fit for your goals (looking for 25% returns?) or your risk tolerance (cannot stand to lose more than 5% a year?).
Rational speculation isn’t for everyone. It takes a keen eye for opportunity or a guide you trust. It takes the ability to see the forest for the trees and understand that big volatility in a small part of your portfolio is much less risky than putting everything on the line and crossing your fingers that another 2008 isn’t right around the corner. It can be remarkably freeing psychologically when you know more of your money is safe.
That’s why we advocate that investors start by assessing their risk tolerance. How much can you afford to lose and still come back to fight another day? Choose a few sectors in which speculate… ones where you believe you can find the kinds of returns to balance the risk you’re willing to take.
Of course, at Casey Research, we’ve spent decades building up our expertise in three areas where we see exactly such opportunities: early-stage gold and other mining stocks; energy exploration stocks; and tech stocks. Those are areas in which we’ve delivered consistently over the years. Even with a two rough years for metals and mining behind us, for example, International Speculator has consistently delivered the kinds of stocks that easily return these kinds of gains per position.
But I would be remiss if I didn’t nudge you in the direction of Casey Extraordinary Technology, our speculative technology research service. Since the day we started publishing, we’ve put up an average annualized return per closed position of 63%. Seven out of every ten stocks we’ve picked have been winners, consistently year after year of publishing. As part of a well-managed speculator’s portfolio, Extraordinary Technology could easily help you outpace the stock market’s typical gains with a fraction of the total risk. Take the service for a spin yourself, completely risk-free. Follow along with our trades for the next 3 months, inspect our complete unedited track record, and see for yourself that there is a different way to manage your money—one where the math works in your favor, not your broker’s.